The concept of angel tax was introduced in 2012 as an anti-abuse measure to deter generation and use of unaccounted money. Section 56(2)(viib) provides that where a private company issue shares at price in excess of Fair market Value (FMV), then such excess amount shall be charged to tax in the hands of the company as ‘income from other sources’. FMV is to be determined in accordance with Rule 11U and 11UA of Income Tax Rules, 1962 or may be substantiated to the satisfaction of AO based on value of assets (including intangible assets). The problem aggravated as valuation is a highly subjective matter. Placing reliance on the satisfaction of AO opened raft of demand notices being sent to startups questioning valuation.

DIPP, in April 2018, released the earlier notification to provide for approval mechanism for availing safe harbour from Angel Tax. However, the arrangement failed to address concerns of startups and investors at large as several startups received income tax notices. In some cases, tax officers even resorted to writing to bankers of the startups and attaching bank accounts to recover the tax amount. Hence, the government has released this new notification in a bid to address the concerns.

Analysis of new notification:

DIPP has now provided for a revised mechanism for startups to avail safe harbour from angel tax retrospectively.

Eligibility criteria for startups: DIPP recognised Start-up are eligible to apply for exemption if the aggregate paid up share capital and share premium after proposed issue does not exceed INR 10 crore. DIPP has not increased this limit and startups having share capital and premium beyond INR 10 crores are still not eligible to apply. It is an acknowledged fact that startup valuations may change drastically based on marketing conditions and performance in due course of time. Moreover, since the provisions apply only to DIPP recognized startups, majority of the startups remain out of the ambit of these provisions. This will discourage larger bets on building unicorns in India. Further, requirement of approval for each tranche of investment (up-to the overall limit of INR 10 crore) still exists even if the investors are same, which may lead to increased compliances and time lag for startups.

Eligibility criteria for investors: Investors should have returned income of INR 50 lakh or more in the preceding financial year (FY) and either its net worth or invested amount should exceed INR 2 crore as on last date of the preceding financial year. The limit on returned income is likely to make small investors ineligible to invest in startups for obtaining approval. However, a positive step in this regard is direct submission of these documents to DIPP, rather than providing it to Start-ups for further submission. This should address concern faced by investors regarding privacy of their information.

Further, the conditions specified for investors are cumbersome and there is no distinction between an investor investing different amount, say, INR 10 lakhs and INR 5 crore. The earlier criteria of average returned income was more relaxed than the new criteria of returned income of the previous FY. Moreover, the investor is now required to satisfy both the conditions simultaneously (unlike earlier where either of the criteria needed to be fulfilled). There also exists ambiguity in the notification due to a possible drafting error as it would be difficult to predict investment amount as on the last date of the FY preceding the year of investment/proposed investment.

Approval process: Approval will now be granted by Central Board of Direct Taxes (CBDT) instead of DIPP administered Inter-Ministerial Board (IMB). This move can also safeguard approved Start-ups from receiving Income Tax notices questioning FMV of shares declared by startups. The new norms are also expected to reduce hassle of the startups as CBDT has been mandated to follow 45-day deadline to approve/reject startup’s request for tax exemption.

Further, doing away with the requirement of merchant banker report is a welcome step. It will now be at the discretion of startup from whom they want to get the shares valued. Only the justification for valuation along with necessary documents need to be submitted to DIPP.

Applicability of the new notification: The notification will apply retrospectively to start-ups that have already raised angel investments in case assessment is pending. This has provided clarity as applicability of earlier notification was not clear on investments already made. Further, it will be a relief for cases that are under process but where assessment order has not yet been passed.

The new notification is effective from immediate effect. However, it will be necessary to also wait for a corresponding notification under section 56(2)(viib) of the Income Tax Act for including such Start-ups under “class of persons” as specified in the section.

This liberalisation is a step forward. We shall keep you posted on further updates.